The Fed’s Teenage Temper Tantrum

Notwithstanding overwhelming evidence to the contrary, the Fed remains steadfast in its refusal to accept any blame whatsoever for the near collapse in 2008 of the financial system it regulates. That said, the Fed is quick to take credit for having saved the system from disaster and for getting the economy back on track. On track? Well, over a year ago, Chairman Bernanke was talking about how the “green shoots” of recovery were increasingly evident. We’re not sure exactly what was green, other than the colossal amounts of freshly printed dollars being thrown at the economy, but just as young plants don’t always survive and thrive, the US economy is clearly struggling again of late, with the broad unemployment rate U6 having risen again to 17.1% in September.

Now it is rare for US central bankers to criticize government economic policy. A quid pro quo of an independent Fed is one that leaves the President and the Congress to their political business, which includes fiscal policy. On occasion, Fed Chairmen have been asked by the President or the Congress to give their opinion on certain policies, in which case they are obliged to offer one up, although normally this is done is an apolitical way.

Even rarer is for a US central banker to voluntarily criticize government policy, rather than as a response to an inquiry on a specific issue. Yet this is exactly what Fed Chairman Bernanke did last week, when he claimed that it would be wise for Congress to systematically exercise more budget restraint, perhaps in the form of explicit budget rules, which have been adopted by a handful of countries and also several US states. That’s right, the Fed’s latest excuse for why the US economy is not performing the way it should is that Congress has been doing a poor job and, as such, business and consumer confidence remain subdued, explaining much of why this recovery has been so weak, notwithstanding the extraordinary degree of stimulus, fiscal and monetary, that has been thrown at the economy since 2008.

While not entirely unprecedented, it is certainly rare for a Fed Chairman to exhort the Congress in this way. One could therefore surmise that Bernanke must feel quite strongly about this matter. By implication, his overt disapproval of chronically high budget deficits implies that he believes it would be better for monetary, rather than fiscal policy, to provide the stimulus necessary to get the economy back on track. While we happen to agree with Bernanke that fiscal policy is not the answer to the current set of US economic woes, we disagree that monetary policy can somehow succeed where fiscal policy fails. This is because US and to some extent global economic problems are structural rather than cyclical in nature. This structural malaise can be seen in various economic “imbalances”, which is econospeak for “unsustainable developments”.

Let’s place the current set of imbalances in context. As we know, the US has long run a current account deficit, implying that it has been consuming and investing more than it has been producing. The net result is a large accumulated debt owed to foreigners, in particular the big savers such as China, Japan, Germany, and a handful of other, primarily manufacturing economies. Now it is one of the basic accounting identities of economics that savings = investment. Money that is saved, even if put in the bank, finds its way into investment, say in the form of a commercial loan which a business then uses to finance new equipment or to hire additional workers. Another identity is that what is not saved/invested is, naturally, consumed. So what we have is: savings + consumption = production (GDP)

Back in the mid-2000s, as the US current account deficit grew and grew, it became fashionable to talk about a “global savings glut” which was “forcing” savings into the US, holding bond yields unusually low and, therefore, stimulating investment in housing and commercial real estate, among other areas. Bernanke himself used this argument in 2005, arguing that high rates of savings, in particular in Asian economies, were responsible for this “glut” of savings. This argument became, for a time, the conventional wisdom. Amongst Bernanke and his mainstream, neo-Keynesian policy and academic colleagues, this remains the explanation to this day for why US aggregate demand is so weak: The world, now including the US, is saving too much.

So when Bernanke was talking about there being too much savings, he was implying either that a) there was too little consumption; or that b) there was too much production. It must be one or the other. Now it is farcical to argue that from 2004-2007, the global economy was consuming too little. Indeed, this was one of the greatest ever consumption booms in world history, led by the US course, where the household savings rate went outright negative. So therefore it must be the case that, in those years, the global economy was producing too much. Yes, that’s right, by claiming that there was a global savings glut, by implication Bernanke was claiming that the world was producing too much! That it was, in other words, overheating! So why on earth did Messrs Greenspan and Bernanke not raise interest rates more, in order to slow the global economy?

The answer, we know, was that US consumer price inflation was low, so it seemed that there was no need to raise rates. But do you see the inconsistency in Bernanke’s argument? YOU CAN’T MANAGE THE RISKS OF DANGEROUS IMBALANCES–SAVINGS “GLUTS”, ASSET BUBBLES OR WHATEVER ONE CHOOSES TO CALL THEM–AND TARGET CONSUMER PRICE INFLATION AT THE SAME TIME! In other words, consumer price inflation targeting is a bogus policy, yet one on which Bernanke has staked his academic and profession reputation. And then, when it all blows up in arguably the greatest credit crisis in the history of the world, he has the audacity to assign blame to anywhere, anyone but the Fed itself–Wall Street, Fannie/Freddie, China, the list grows and grows–and now at the US Congress!

When a young child is caught misbehaving, sometimes they attempt to make some simple excuse to talk their way out of it, only to find the parent knows better than to believe them. As the child grows, the excuses grow ever more complex in an attempt to obfuscate, deceive, bewilder or simply exhaust the parent into retracting an accusation. However, when a teenager is caught, rather than make increasingly elaborate and frequently futile excuses, it becomes more common to simply blame the parent!

Once upon a time the Fed used to make simple excuses such as “no one could see the bubble”, which was used following the dot.com crash in 2001-03. Then the Fed began to make increasingly elaborate, bewildering and, as demonstrated above, internally inconsistent excuses such as there being a “global savings glut” which the Fed could do nothing about. Now the Fed is blaming the Congress that created it and lightly oversees it for US economic woes. We’re sorry, but this sounds like a teenage temper tantrum to us, not the rational voice of a sensible, competent institution ready and willing to take responsibility for its actions past, present or future. It is a sign of a teenager maturing into an adult when they not only stop making excuses generally but, even to the extent that they feel their parents are to blame in some way for their foibles, they move on, get over it, take responsibility and make the best out of the imperfect situation known as the human condition. If the Fed is indeed on such a path, then maybe there is some hope after all. We need only be patient, as all good parents are.

[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]

About John Butler:

John Butler has 17 years experience in the global financial industry, including European and US investment banks in London, New York and Germany. Recently, he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, responsible for development and marketing of proprietary, index-based quantitative strategies in global interest rate markets. Prior to DB, John was Managing Director and Head of European Interest Rate Strategy at Lehman Brothers in London, where his team was voted #1 by Institutional Investor. He has contributed to financial publications including the Financial Times, Wall Street Journal, Boersenzeitung and Handelsblatt.